Miners' Many Hurdles Keep A Lid On Gold And Silver Stocks

Includes: AG, AUY, EXK, KGC, SSRI
by: David Urban

Investors in gold and silver mining stocks in 2011 have been left wondering why they are underperforming, despite record gold prices and margins.

There are a number of factors which have helped to constrain stock prices this year.

Building a mine is a time-intensive and expensive process that takes years to complete. One has to deal with drill results, 43-101 estimates, pre-feasibility studies, feasibility studies, and the permitting processes, which include environmental surveys and community discussions over issues such as waste water management, power acquisition, and the use of hazardous chemicals. All of this takes years before the first equipment is ordered and the construction process begins.

Once construction starts, a whole new set of issues pops up, from obtaining building materials and mining equipment to getting it on site on time and on budget. The pressure then builds to deliver the mine on budget and on time. This is no easy feat when the location may not be accessible 12 months of the year because of weather or poor regional infrastructure.

Finally, when the mine is built and operational, there are issues with equipment that can range anywhere from obtaining tires for mine trucks to problems with the mill or lower than expected recovery of ore grades.

I have yet to mention the operating environments, some of which can be less than friendly. Inflation is rearing its head globally, showing up everywhere from food, labor, fuel, strikes and riots in addition to sovereign problems. Countries around the world are discussing raising mining royalties in an attempt to cash in on high commodity prices to cover budget deficits.

Mining is a difficult and time-intensive job, and execution is the key. So far this year problems at mines are causing solid management teams consternation as they miss estimates. Investors wondering why their mining stocks are lagging may want to check to see how management is executing on their 2011 forecasts. We are coming close to the end of the third quarter, and people will be wondering if forecasts will be revised come the end of the second quarter.

This is not to say that the management of mining companies is not of high quality, as many issues are out of their hands and specific to the locations in which they operate.

A factory which makes consumer products or widgets takes much less time and can be placed almost anywhere in the world. If a product is seeing slower than expected sales, there are a number of items a company can do to bump up sales such as increasing advertising or discounting.

Mining is a bit different, because mine owners are beholden to the grades of the ore being pulled out of the ground. Local communities are generally supportive of a factory being built, due to the jobs being created. Mining districts, on the other hand, can run into local opposition as communities may worry about the potential use of hazardous chemicals and post-mining reclamation projects.

We are in a period where we are transitioning from stage two to stage three of this bull market for gold. In this transitional phase, the market is looking for the companies to deliver on guidance, and those that deliver on said guidance will be rewarded with higher stock prices.

What should a small investor be looking for in a mining stock? Managements that are delivering in these uncertain times, effectively managing risks and successfully hedging their cost structure while delivering on production and cost guidelines.

Investors might consider Kinross Gold (NYSE:KGC), whose stock has been beaten down but on a reserve and resource basis is quite inexpensive. Yamana Gold (NYSE:AUY) continues to see significant success in its organic exploration program and plans on upping production by 40% over the next few years.

In the silver equities space, Silver Standard (NASDAQ:SSRI) is moving forward, with its mines adding equipment and strengthening its build-out staff. First Majestic (NYSE:AG) has delivered on expectations from the start of the year, and Endeavour Silver (NYSE:EXK) ramps up production and plans on taking their business model outside of Mexico to Chile.

Disclosure: I am long AUY, AG, and EXK.

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